Since a 2006 law allowed the creation of Roth 401(k)s, more and more companies have added a Roth 401(k) option in their retirement plans. However, a recent nationwide study shows that only 14 percent of employees are using this option. The problem: Many people don’t know they have this option, and those who do often don’t have any idea whether to use it. As a result, few workers are choosing the Roth 401(k), even though many could benefit from it.
How it Works
Roth 401(k) plans allow employees to set aside part of their paycheck for retirement while providing unique tax advantages that allow more of that money to remain in your wallet throughout retirement. For example, contributions to a Roth 401(k) plan are made with after-tax money, and, given that employees pay the tax on those contributions upfront, distributions from a Roth 401(k) plan are typically tax free – this is assuming that the plan is at least five years old and that the owner is at least 59 1/2 years old. Contributions to a traditional 401(k), on the other hand, are made with pre-tax dollars. This lowers your tax bill now, but the downside is that, unlike a Roth 401(k), withdrawals are typically taxed as ordinary income.
Benefits
A Roth plan offers advantages for many retirement savers. It’s also generally a more flexible tool than a traditional 401(k). With a Roth, workers trade some upfront pain for a long-term gain. They pay taxes on their retirement savings now so they don’t have to pay taxes on withdrawals in retirement. The young benefit most from this strategy, because they have more time to let their money grow tax-free. Also, any workers with low to moderate income should use Roths if they expects to earn significantly more later in their career.
The wealthy can also benefit from a Roth 401(k), because of the flexibility it offers. For example, a retired couple wants to splurge on a $40,000 round-the-world cruise. If they take that money from a traditional retirement account, they’ll need to pay taxes on it. That one-time expense may bump them up to a higher tax bracket. But any withdrawals from a Roth 401(k) are tax-free, so retirees can cover big expenses without worrying about the tax consequences.
If you withdraw money from a traditional 401(k) plan before you turn 59 1/2, you pay both taxes and a 10 percent penalty. There’s no penalty for withdrawals from a Roth 401(k), as long as you take back only the amount of your original contribution and leave any earnings in the 401(k).
Another way Roth accounts are more flexible than traditional ones: By law, retirees must make regular withdrawals – “required minimum distributions” – from their traditional retirement accounts after age 70 1/2. But retirees can leave assets in a Roth account for as long as they want.
Considerations
Roth plans could end up being a bad deal if lawmakers eventually lower income tax rates and replace them with value-added or sales taxes. Roths would become a better deal, though, if the income tax burden on seniors goes up.
In the end, it’s always a good idea to make sure your retirement money is “tax-diversified,” meaning split up among accounts that are tax-deferred until retirement, and accounts that are already settled up with Uncle Sam.
Regardless of whether you decide on a Roth 401(k) or a traditional 401(k), what matters most is that you at least pick one and contribute as much as possible to it every year. Discuss your situation with your financial adviser and tax professional to chart the best course for your retirement plan. n
Matthew M. Neyland is director of investments at SK Wealth Management.
